Asia Pacific the new growth hub for ETFs

Cerulli: Asia Pacific Edge, December 2010

The Asia Pacific-region remains a modest centre for exchange-traded funds (ETFs) in global terms, but its rate of increase in recent years has been almost peerless. The size of the industry in Asia has increased almost fivefold from US$10.5 billion in 2005 to $48.2 billion in 2010 today, bringing its representation in the global ETF universe from about 2.5% to 4.5%. While the overall volumes are dramatically higher elsewhere in the world – US$715.7 billion in the US alone – only Europe can really compare with Asia in terms of the pace of growth in the last five years.

All of the larger Asia Pacific markets have begun to embrace ETFs over this period, with Korea – with 55 ETFs as of April this year – leading the way. Yet there is also very clear room for growth, both in terms of total products – there are, for example, just three each in Malaysia and one in Indonesia – and in assets under management.

This review will focus on two quite different markets to give a sense of evolution and direction: Australia and China.

Australia for many years was served by a handful of long-running products based on local stock market indices from State Street Global Advisors, chiefly for the S&P/ASX200, and subsequently for the ASX50 and a listed property index. Next iShares, now owned by Blackrock, began launching international ETFs, and at the time of writing offers 19 in Australia, from global equity and emerging market indices to single-country funds based on indices in China, Korea and Taiwan. iShares says financial advisors (who are exceptionally powerful in Australia) use them as building blocks to create global equity portfolios and implement long term strategic asset allocations for clients.

Others have begun to enter the market. Australian Index Investments joined the fray this year with six sector-based ETFs, for resources, metals and mining, energy, industrials, financials, and financials ex-property trusts. ETF Securities has launched exchange-traded commodities, based on gold, silver, platinum, palladium, and a basket of precious metals; each are backed by real, physical metals. And Vanguard, long champions of passive managed funds, has created three ETF versions of its index funds, both domestic and international, listed in Australia. The 33 listed ETFs in Australia by September 2010 had a combined market capitalization of A$3.94 billion, up almost 40% on the previous year, which in turn was up 158.1% on the A$1.095 billion in September 2008.

But what’s particularly interesting is what has come next. In May this year Russell Investment launched the Russell High Dividend Australian Shares ETF, which was subtly different to previous offerings because it was based not on a widely known index but a customized one built by Russell itself, skewed toward companies expected to pay above average dividends – which is, in some respects, an active decision. It has since been followed by a similar product from State Street, which also is based on an index invented (by MSCI in this case) to focus on high dividend yield companies that are likely to be sustainable in that approach.

These new issues bring ETFs in Australia into unfamiliar territory: involving active portfolio construction in what has typically been a purely passive part of the market. And in this respect, it may mark a first stage of ETFs maturing towards the range of product found in Europe, the US and UK: leveraged ETFs, swap-backed ETFs with only synthetic exposure to the assets they give exposure to (as is common with oil ETFs for example), and even inverse ETFs.

Since sentiment about these structures is mixed – the Bank of England warned about them this year – there are correspondingly ambivalent feelings about what sort of reception these might get in Australia. But there’s no question ETFs as an investment class are growing. This is partly because until recently most financial planners charged through trail fees, which naturally disadvantaged ETFs since they don’t pay them. Regulatory change has prompted more planners to charge on a fee for service arrangement, in which trail fees aren’t relevant and so ETFs compete on a more level playing field. And even if more esoteric structures take a while to arrive in Australia, it would be a surprise if the market does not soon see ETFs based around other asset classes such as bonds and more commodities.

China is an interesting market to watch for other reasons, as it shows what sort of traction ETFs can achieve when they appear at the early stages of a market’s development. In the first four months of 2010, China had by far the greatest net new inflows in the region into ETFs: US$2.89 billion, more than 10 times greater than a more mature market like Singapore.

China is the sort of market where people follow trends, and until recently those trends have very much suited ETFs: a heavy momentum market (both upwards and downwards over the last few years) where the perception is that active management will not make much of a difference to returns. Correspondingly many of the largest fund managers in the business have been busy with launches: China Asset management and E Fund Management have two each, while others have been launched by managers including Bosera, Bank of Communications Schroders, Hua An, Fortune SGAN, ICBC Credit Suisse, China Southern, AIG-Huatai and – with two in September alone, though one a related feeder fund – HFT Investment Management. First mover advantage has proven tremendously important here: China AMC (which launched the first ETF in 2004) and E Fund management (whose SSE 100 ETF in March 2006 was something of an industry landmark) account for 73.5% of the market, according to Blackrock.

While many managers are still getting started with ETF launches, there is already a degree of specialism. Some, such as one from China AMC, have a focus on small to medium enterprises; E Fund has a fund focusing on mid-caps, Bosera on large caps. The new HFT product in September was called the Shanghai Cyclical Industry 50 ETF, bringing something of a sector theme to the industry. And CCB Principal has launched one based around socially responsible investment. So far, though, all are equity-related, and there is enormous scope for further industry development.

China is also interesting because of a structural quirk. In China, ETFs are packaged and sold just like any open-ended mutual fund, rather than the share-style exchange-traded purchase and sale that is commonplace elsewhere in the world. One knock-on effect of this is that, unlike most of the world, the bank channel is a major method of distribution for ETFs in China; and, correspondingly, they tend to have large front end fees, typically over 1%, attached to them, which again is unheard of in most ETF markets. Indeed, most would consider this to defeat the point of ETFs, since they sell so strongly on their low-fee, exchange-traded simplicity. But it hasn’t, yet, dented popularity in China, it would appear.

Broadly, Asian ETF markets are still at a fairly mainstream phase of development. The vast majority of products are related to equities, although one can find fixed income vehicles in Hong Kong, Korea and Singapore, and commodities ETFs in Korea, Singapore and Australia. They are, too, overwhelmingly single-country in their focus: 93.7% of Asia Pacific ETFs fit this description, according to Blackrock.

In terms of product innovation, the most exciting market is probably Korea. Consider some of the product launches in 2010: there has been an inverse ETF, launched by Woori; leveraged ETFs, from Mirae, Kodex and KB KStar; sector-specific launches, such as Hyundai’s based on insurance equities; one based on West Texas Intermediate oil futures, from Mirae; and a money market ETF from KOSEF. But of those, only the Kodex leveraged fund and the money market product raised significant funds and has over US$100 million in assets under management; the rest are mainly interesting but somewhat underused so far. In Hong Kong, too, there are signs of growing maturity, with a host of sector-specific A-shares funds launched by iShares in November 2009, for example. But largely, the enthusiasm in the region appears to be for straightforward, index-based, country-specific product.

One interesting question, being discussed widely in China right now but relevant across the region, is whether the more volatile markets typical of 2010 favour active management, and whether that in turn diminishes the appeal of ETFs. Fund managers tend to see a use for both, while financial planners like the flexibility of ETFs to put a portfolio together with a combination of passive and active components.

In sum, it makes sense to expect rapid expansion in ETFs in Asia, in terms of overall assets, number of products, and variety of underlying asset classes. Fees may not be great outside China, but the momentum suggests they will be lucrative for managers who design and market their products carefully.